Councils responsible for £180 billion of pension funds have defied UK government pressure to seek savings by switching their funds to passive management.

Local authorities across England and Wales have strongly defended the City’s active fund managers, with accusations that the analysis that supported passive investment is “flawed and inaccurate”.

A report into the schemes’ management costs by the investment consultancy Hymans Robertson, prepared for the government last year, appears to have convinced the government that a wholesale move to passive investment would save around £420 million a year from the schemes’ £790 million running costs “without sacrificing investment performance” as, in aggregate, council funds’ equity investments had failed to beat the relevant market indices.

The government issued its proposals in May, and its consultation period closed earlier this month. Not all the 89 local authority funds have responded but Financial News has studied responses from the 38 that have made them public, which included some of the largest schemes.

Their reaction to being forced to go passive ranges from disquiet to outrage. Nick Vickers, head of financial services at Kent County Council, said in his response that “the consultation document is significantly flawed and the headline savings figures are unsound”. The Cheshire Pension Fund told the government: “We are advocates of active managers.”

Others praised their own fund managers for delivering the goods. The Northamptonshire Pension Fund said it was “not surprised” that councils’ overall returns had not beaten the indices – but added “we do not think this is an indictment of all active managers and nor should it be a reason for [council funds] to settle for mediocrity”. It said its managers – Majedie, UBS, Schroders, Skagen and Baillie Gifford – had outperformed.

All 38 consultation responses seen by Financial News rejected the idea of compulsory passive investments. A softer government proposal was backed by 27 – a “comply or explain” approach that would oblige council funds to explain why they had picked active managers.

Council officials at Essex said in their response: “We believe the Essex fund already sets its investment strategy with a full explanation of the rationale and, therefore, this is our preferred option.”

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Several councils questioned the analysis done by Hymans Robertson, which the government has used to support and underpin its recommendations.
Mark Lyon, head of investments at the East Riding of Yorkshire’s pension fund, delivered one of the most stinging verdicts, calling the report “inaccurate, incomplete and lacking in depth”.

He said: “One of the problems is they didn’t consider risk-adjusted returns.” Hymans compared total average returns to indices, he argued, and found no significant outperformance – but this fails to consider whether managers are providing a “smoother ride” for pension funds, meaning fewer wild swings in their deficits and less volatility in the taxpayer’s bill for pensions.

Linda Selman, head of Local Government Pension Scheme investments at Hymans Robertson, and responsible for its report, said: “I wouldn’t disagree at all that it’s better to look at risk-adjusted returns, but those figures simply aren’t available for the local government scheme.”

But Lyon said he had done some risk-adjusted return calculations of his own, and found a “modest outperformance in equities” for the LGPS. Other respondents to the consultation, such as the Investment Management Association, questioned the way Hymans had incorporated transaction-cost analysis into its figures, and the way the government then presented the £190 million difference between active and passive transaction costs as a potential “saving”, alongside £230 million in active-manager fees.

The IMA’s response observed: “Transaction costs clearly matter significantly to overall return, but are accounted for within it. For example, in UK equities, the gross outperformance within the Hymans’ sample, albeit small at 0.1% in the selected mandates, is net of any transaction costs. The starting point, therefore, [of a move to passive] will be a loss of 0.1% and no savings.”

But Selman said the transaction-cost calculation had been in the job description Hymans got from the Department for Communities and Local Government: “We were asked to calculate the all-in costs of active management. It’s not to say that active management is wrong – and in our response to the consultation [a separate document to the cost analysis] we recommend greater use of passive, but are quite clear that it shouldn’t be 100%. But active management does come with a cost.”

Hymans’ estimate for transaction costs – 0.2% of total LGPS equity assets, or £226 million – also looks large when compared with detailed analysis run for the West Sussex Pension Fund, which estimated the cost at about 0.12%, just over half Hymans’ level. If that applied nation-wide, the total bill would be £134 million, not £226 million, and presumably the potential “savings” would also be lower.

Selman said: “The transaction costs for individual funds will vary. It depends on what fund managers they are using, what their stock turnover is and how good the manager’s dealing desk is. Again, we were asked to look only at the aggregate.”

Collective investments

However, the councils have largely backed, in principle, another of the government’s Hymans-inspired ideas – the setting-up of Collective Investment Vehicles, a number of national or regional fund structures in which councils could pool certain kinds of investments, gaining economies of scale.

The government has asked for thoughts on how many there should be, what assets they should invest in and what legal form the structures should take.
Some councils proposed that these should focus primarily on alternative assets, arguing this is where the benefits of collective bargaining power on fees would be most felt. The Greater Manchester Pension Fund, at £13 billion the largest in England and Wales, said in its response: “Given our size, we are already able to obtain relatively low management fees for listed investments that are managed actively or passively… for the larger funds, collective working is most attractive for some alternatives.”

The handful of large council funds that are managed internally, including Teesside, South Yorkshire, West Yorkshire, West Midlands and East Riding, argued that collective vehicles were probably not for them, as their running costs were already low.

Geik Drever, director of pensions at the West Midlands Pension Fund, said that her fund had a “substantial internal investment team, within which there is a successful function dedicated to passive index tracking of developed quoted equities markets”.

She added: “The latter has been delivered at less than half of the cost than the estimates of the equivalent services as reported in Hymans Robertson’s report.”

This article was first published in the print edition of Financial News dated August 4, 2014